Dot-com dogs

With Net-stock fever showing no signs of cooling, mediocre IPOs are growing as plentiful as fleas on a stray hound.

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Going public,” circa 1990: Build a company with substantial revenues and growing profits. Sell shares in it to investors who hope it will grow even bigger.

“Going public,” circa 1999: Start a company, add a “.com” to the name, sell shares in it to investors who hope to make a quick killing before the Net frenzy ends.

There is hardly an investor who does not profess to believe that the frenzy for Internet stocks is a bubble waiting to burst. Yet the dot-com stock fever continues unabated. In November alone, 40 companies filed documents with the Securities and Exchange Commission announcing their intention to go public. Most are building their businesses around the Net, or at least claiming to.

Surely, not every firm that can boast of some relationship to the Net deserves a stratospheric valuation. Yahoo’s market capitalization — the total value of its stock — is now over $80 billion. That’s more than Disney — a huge media conglomerate that owns a television network, movie studios, and, yes, its own Web portal. A share of Yahoo now costs over $300, and for each share Yahoo earned all of
25 cents in its last quarter. That leaves a ridiculous amount of ground for Yahoo to cover before its stock becomes a sensible purchase by any traditional metric.

But investment bankers continue to roll out companies they hope will catch the fancy of dot-com investors. The trouble is that many of these companies are unlikely to ever show a profit, and the bankers must know it. If truth be told, a lot of them seem designed to attract speculators who hope to make a quick buck selling their shares to someone else before the bottom drops out of the market.

What in more rational times would be considered mediocre IPOs are plentiful. Dozens of companies have filed documents with regulators that tell prospective investors that they have never made a profit and, moreover, expect no profits in the foreseeable future. There are more than a few — like Buy.com, or video retailer Reel.com — that lose money on everything they sell and hope to make it up on volume. There are others, like RealNames that have little more than one idea (in RealNames’ case, giving Web browsers shortcuts to popular Web addresses) and an unusually punctuated name. Still others are just older companies with a dot-com smiley face drawn on them. Harris Black has been in the polling business since 1959, but it took a name change to Harris Interactive to get to an IPO and a $600 million market value.



Among the surrounding pitiful prospectuses, some soon-to-be-public Net companies stand out as more egregiously awful than the norm. How bad have things gotten at millennium’s end? I took a tour through the upcoming offerings to find the mangiest dogs — companies that might make a killing in the public markets, but look awfully unlikely to be big successes for the long term.

There were two criteria for getting on this short list. First, the initial public offering had to be underwritten by a major, reputable investment bank (there are plenty of blatant rip-offs among the tiny offerings underwritten by marginal investment bankers, and spotting those is just too easy). Second, there had to be something badly wrong with the company — not just bad ideas or big losses, but the faint stench of a company that’s a non-starter at best or a rip-off at worst.

How2.get big bucks

If you follow the parade of emerging dot-coms, the name “How2.com” may sound vaguely familiar. If you follow Silicon Valley goings on, you might think that it’s a start-up funded by the prestigious venture capital firm Hummer Winblad, a kind of guide to anything and everything on the Web. But no, sorry, that’s eHow.com. You might, if you happen to live in San Francisco, think you’ve seen dozens of billboards advertising the company’s Web site. Wrong again, but close. That’s Learn2.com.

How2.com has a lot in common with those other start-ups. Like them, it manages a Web directory that gives advice in a question-and-answer format. Mostly obvious advice, like this introduction to a section on how to cook shrimp:

Like most things that are worth doing, cooking shrimp is worth learning to do well. Shrimp is a delicious, succulent, mild-tasting crustacean that complements any type of cooking and crosses many ethnic culinary boundaries.

You have to click through to the next page to find any actual instructions.

The How2.com guide to how to choose fresh fish lists the habitats of 28 species of fish, taken from the National Fisheries Institute — but not one way of telling if the fish lying on the supermarket counter is really fresh or has been sitting on ice for a week.

One big difference between How2.com and its lookalike competitors is that How2.com’s founders and backers have a superabundance of chutzpah. In October, the company announced plans to sell $125 million of stock to the public. That’s a lot of money — a lot of tech company IPOs raise under $100 million; Yahoo’s IPO in 1996 asked investors for only $37 million.

If you ask me, How2.com is hands down the worst major upcoming dot-com offering. Start with its history:

How2.com is a spinoff of a small security-software company called Citadel Technology. Just a little over a year ago, Citadel completed a stock offering of its own. The offering price was a mere 75 cents a share — penny stock territory, a sure tip-off of a marginal company whose founders are looking to cash out with a quick pop in the stock’s price. Right now, Citadel’s stock trades for a little over $2 a share on the Over-the-Counter Bulletin Board, a happy hunting ground for companies too small and risky for the NASDAQ national market.

Before he invested in Citadel, company
CEO Steven Solomon ran a chain of five Miami Subs fast-food restaurants. The
relationship between Solomon and Citadel’s finances is awfully close. Over
the past year, Citadel has given Solomon more than $1.5 million in low-interest loans
(most of which he has repaid). Solomon is a busy man — in addition to
running Citadel he also serves as CEO of, yes, How2.com.

Take a close look at How2.com. Naturally, it has existed only since January 1999. But going public within a year of launch is just about on par with the average dot-com. In the first six months of this year How2.com has had revenues of just $872,553. That’s not much for a company trying to go public, but there’s nothing really extraordinary there.

No, the really strange thing about How2.com is that its main line of business isn’t Net-related at all. In May, How2.com acquired a company that administers consumer rebate programs. If you buy a VCR in a store and get a coupon that you mail in to get $20 back, your coupon might go through How2.com or a company like it. The company’s prospectus doesn’t break down the revenue from its different lines of business, but says that what revenue it did have came primarily from its rebate operation. So if you read the fine print, you find that How2.com isn’t a Net business at all — it’s an insta-Net company that bought a traditional rebate business, apparently to pump up its revenue line, and is trying to get $125 million from the public with a catchy dot-com name.

The “concept play”

If ever there was Net company ready to go public on the strength of hype alone, it’s the Digital Entertainment Network. In September, DEN filed a preliminary prospectus with the SEC as thick as a telephone book.

It’s not likely that many people read all the fine print; DEN had all the right keywords. Prestigious New York money, a Santa Monica office near enough to Hollywood and a great story about providing broadband entertainment over the Internet to “Gen-Y.” It’s not clear what exactly Gen-Y is besides a fancy term for “people in their teens and early 20s,” but marketers do love it. Most of all, DEN seemed to have real technology chops.

The founders, Marc Collins-Rector and Chad Shackley, had earlier founded a successful network-services company, Concentric Network. Collins-Rector was the businessman and Shackley, DEN’s chief technology officer, was the techie boy wonder. Shackley, in fact, had been just 18 years old when the two started Concentric. Concentric has since gone public and hit a $1 billion market valuation — though Shackley and Collins-Rector have not been involved in management since 1995.

DEN’s founders were undoubtedly aware that big media companies have failed miserably in their efforts at interactive entertainment. But letting some techies — and especially a tech head still in the MTV demographic — give it a try sounded like just the thing. DEN, which launched in May, promised streaming video over the Net, on demand, and with tiny production costs to boot. But the “content” plays in tiny windows, no more than 2-by-2 inches on a typical computer screen. A bit of a tight fit for Gen-Yers used to 25-inch television sets.

DEN is the ultimate “concept play.” Its revenues for the first half of 1999 weren’t just small; they were zero. But for a concept play — a stock in which investors put their money not because they’re impressed by the financials but by the idea — that’s not necessarily a bad thing. After all, when you start at zero, it’s easy to show growth, and the upside is unlimited.

Buried deeper in the financials, however, are some numbers that make more seasoned tech investors blanch. David Neuman, the president and a onetime senior Disney exec, gets a salary of $1.5 million a year, plus a $1 million signing bonus.

In the Net world, megabucks option grants are routine, but million-dollar salaries are almost unheard of. (The historical role model is Netscape, whose CEO Jim Barksdale was so well sated on stock that he forewent his salary.)

Neuman wasn’t the only one with a seven-figure salary, either. Marketing head Edward Winter takes home a $1 million annual paycheck — not bad for marketing a company with no revenue.

If all this sounds bad, about a month ago it got even worse. At the end of October, Collins-Rector resigned after settling an ugly lawsuit that BusinessWeek reported involved allegations that he had sexual relations with a 13-year-old boy. Shackley resigned also.

Collins-Rector and Shackley reportedly lived extravagantly in a mansion once owned by jailed rap impresario Suge Knight. Some observers saw their departure from DEN as a welcome sign that the company’s profligacy was at an end. But remember: Neuman and Winter got the seven-figure salaries, and they are still on board. Now DEN has lost its key founders, but it still has enough highly paid Hollywood execs. Surely that’s a recipe for success, right?

IPO first, business later

Imagine that someone comes up to you and asks you for money to buy two bicycles. He is nicely dressed, in an expensive suit. Perhaps he is a professional financier. He tells you that if only you give him enough money for the two bicycles, you’ll get to own one of them.

Great deal, huh? Well, that, more or less is what Espernet is proposing to do.

Espernet is an Internet service provider, a fairly straightforward and — unless you’re America Online — money-losing commodity business. Well, that’s not quite right, Espernet is going to be an Internet service provider. As soon as investors give it the money.

Here’s how it works: Espernet plans to buy 43 smaller ISPs, with a total of 274,000 subscribers. To buy the ISPs, it will spend about $173 million in cash and stock. Where will all that money come from? You guessed it: an initial public offering for a company that for all practical purposes doesn’t exist.

Espernet is the ultimate evolution of what in the financial world is known as “roll-up” strategy. A company pursuing a roll-up strategy grows by buying smaller companies, usually paying for the acquisitions in stock. The idea is that the whole is worth more than the sum of its parts.

In this case, Espernet is planning to raise up to $172.5 million to pay for its acquisitions. It sounds good — after all, the end result will be a company that owns 43 ISPs, for which it will pay $173 million. But the important thing to remember is that investors in the public offering won’t own the whole company. They put in $172.5 million for only a piece of it. The rest would be held by current investors and management.

Espernet has yet to disclose the exact percentage of the company investors will get for their $172.5 million — that will come in later revisions of the company’s SEC documents. But the prospectus does say, in boilerplate legalese, that investors in the public offering will “suffer immediate and substantial dilution.” That’s the legal way of saying that Espernet will use the investor’s money to buy two bicycles and the investors will get to own one. Of course, what’s involved here isn’t two bicycles but 43 ISPs, and the fraction that new investors will own won’t be exactly half — it could be a whole lot more, or a whole lot less, but the principle is the same.

Even if it were certain that the whole would be worth more than the sum of the parts, this would be a very iffy proposition. But even that is by no means certain. Other Internet service providers, such as Onemain, have found that hooking up a bunch of disparate ISPs just gets them a lot of incompatible equipment and mismatched systems. And running small Internet service providers is a very expensive proposition indeed. Onemain lost over $45 million in the six-month period that ended in September 1999. (Onemain.com’s stock rocketed to $46 a share and now languishes below $20.)

Taken together, the 43 ISPs that Espernet plans to buy lost $33 million in the first half of this year alone. So in some ways it’s a good thing that Espernet will have plenty of money in the bank.

In the IPO game, no one is wholly innocent. Even some avid dot-com investors figure that when the music stops playing, someone will be left holding a bag full of stock in failing companies. They just hope it won’t be them.

So who really benefits? Most of all, the management and early backers in the truly doggy dot-coms. Sure, the stock is going to drop sometime in the future, but by that time, in many cases, top management will have sold part of their holdings and made an easy fortune. The worst dot-coms will go public with a bang — but eventually some of them will go broke with hardly a whimper.

Mark Gimein is a staff writer for Salon Technology.

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